Professional Documents
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Risk
capacity Capital
Strategic Compliance
Risk
Operations Financial
tolerance
Risk appetite correlated to risk category
Whereas breaching a risk tolerance level should be a red alarm performance. Many telecom companies decided to embrace more
light for management – the risk position must be reduced – risk taking during the last two decades of the 20th century because
breaching a risk limit acts more like a yellow warning light: we are of changes in their regulatory environment – liberalization – and in
deviating signicantly from our risk target – action is required technology – digitalization, internet – which transformed their
unless there are good reasons to maintain our current risk level. business and drastically increased competition. As discussed in our
This exibility in reacting to the breach of a risk limit is the paper Speed through common language. Critical factors in risk
consequence of a simple fact: risks change continuously. management today, it is vital for companies to react quickly to
Therefore, a denition of risk appetite cannot be a one-off exercise. changes in their risk environment. This reaction can include
Risk appetite, tolerance, targets and limits are not static. They corrective actions, but also appropriate modications in risk
must be updated with changes in a company’s environment targets, limits, tolerance and appetite if and when necessary.
(economy, markets, regulations, technology etc.), strategy and
Risk exposure
120 Actual risk exceeds
risk tolerance, must
reduce net risk
110 position
Risk 100
tolerance Actual risk exceeds
risk limit, manage
Actual risk 90 down unless returns
position justify risk position
80
Risk limit
(high end)
70
Time
A company can monitor and manage its most important risk
targets, limits and tolerance through a set of key risk indicators Tackling risk appetite: Are you ready?
(KRIs). KRIs can be expressed in a variety of units, according to
the specic risk under discussion: a percentage of faulty products, Various surveys conrm that many board members of even
a number of hours lost due to work-related accidents, a monetary the biggest companies do not have a clear understanding of
value such as net debt or a ratio, e.g., EBITDA/interest expenses. their company’s risk appetite and risk tolerance. According to
Of course, great care should be taken when dening a KRI: is the a 2008 ERM survey by Towers Perrin, less than half of
KRI really measuring what we want it to measure? And if so, are we respondents had a documented risk appetite statement in
measuring it correctly? place (quoted in “Emphasis”, 2009/1). A study by the
Conference Board (CEO Challenge 2006. Top Ten
In order to balance risks and opportunities correctly and to obtain Challenges) quoted by the Risk and Insurance Management
the best possible alignment of performance management and risk Society in its publication The 2008 Financial Crisis. A
management, each KRI should be linked to a key performance wake-up call for enterprise risk management, found that a
indicator (KPI). KPIs have long played an essential role in meager 54% of directors of US Fortune 100 companies
performance management. As explained in our paper A new understood their company’s risk tolerance, which means that
balanced scorecard. Measuring performance and risk, one of the almost half did not. So either risk tolerance levels in those
most effective ways to link performance and risk management is to companies have not been dened at all or board members
integrate risk factors and risk management in a company’s were not actively involved in this process. Other studies
performance management tool of choice. Currently, the Balanced suggest that most companies do not dene and measure risk
Scorecard (BSC) is by far the most popular such tool. For each of limits on a consistent basis throughout the company.
the four main areas in the classic BSC (market; operations;
organization; nance), a company denes its goals and the related From our discussions with board members we have the strong
KPIs. By enhancing the BSC with KRIs, a company can integrate impression that this lack of explicit, structured focus on risk
performance and risk management; it can measure and monitor appetite and risk tolerance we see at many boards is not due
performance and risk at the same time, as part of the same to an unwillingness to deal with the issue. To the contrary,
process. board members tend to understand the importance of
dening and dealing with risk appetite in a coherent, structured
way, but do not know very well how to go about it. Hence the
importance of providing boards and executive management
with the right approach and tools to tackle the issue.
Financial
“To succeed Objectives
financially, KPIs
how should we Measures
appear to our Targets
stakeholders?” KRIs
Initiatives
Source: Adapted from The balanced Scorecard by Dr. Robert Kaplan and Dr. David Norton
Norman Lonergan Global Vice Chair + 44 (0)20 7980 0596 Ernst & Young’s
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The relationship between risk and
Andrew Embury EMEIA + 44 (0)20 7951 1802 performance improvement is an
increasingly complex and central
business challenge, with business
Nigel Knight Far East + 86 21 2228 2189
performance directly connected
to the recognition and effective
Isao Onda Japan + 81 3 3503 1100 management of risk. Whether your
focus is on business transformation
Doug Simpson Oceania + 61 2 9248 4923
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